Playing the yield curve

This article was first published on Patreon on 5 July 2018

A week ago I wrote about the low-hanging fruit of macro investing. And the gist of that post was that a lot of investors get the macro story wrong because they fail to understand the economics. I gave two specific examples where people have it wrong: the Japanese government bond yield play and the Chinese US Treasury bond play.

Today I want to focus on macro strategies I think make sense. And I want to come back to the Chinese case to lead in to this.

It’s the currency release valve for the Chinese

On Tuesday, I sent this tweet about the Chinese currency market:

Interesting. Another interpretation is that the market is forcing the peg lower as evidenced by a widening spread between offshore and onshore yuan

— Edward Harrison (@edwardnh) July 3, 2018

That was in response to Joe Brusuelas tweet:

Notice the surge in CNY? That is the Chinese government signaling it intends to use financial weapons in what is increasingly looking like a trade war. That way lies perdition. So what is an optimal tariff regime in such a war? Has the admin prepared the public adequately?

— Joseph Brusuelas (@joebrusuelas) July 3, 2018

The chain of tweets following from this involved Jamie McGeever at Reuters and Brad Setser at the Council on Foreign Relations. And it was a very good back and forth about what the Chinese can do and are doing with their currency and why? There’s a lot of speculation about the weakening of the Chinese currency due to the trade war building between China and the US.

But notice: no one is talking about dumping Treasuries. If you go back to the wrong-headed Wall Street Journal article I mentioned last week, you would think this was a choice. That’s how the writer makes it sound. It’s not. Bond vigilantes don’t force up rates in sovereign currency areas. They anticipate inflation and interest rate hikes. The currency is the release valve for so-called bond vigilantes. And that’s why the Chinese peg is going down as the Fed tightens. Other CBs are just not as hawkish, including the Chinese central bank, the PBoC.

How do you play the US curve then?

So the yield curve in sovereign currency areas is all about macro then. And by that I mean the macro environment and the central bank’s reaction function given that macro environment.

Look at former Fed Chair Greenspan’s comments from February 2005 for example:

long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. The simple mathematics of the yield curve governs the relationship between short and long-term interest rates. Ten-year yields, for example, can be thought of as an average of ten consecutive one-year forward rates. A rise in the first-year forward rate, which correlates closely with the federal funds rate, would increase the yield on ten-year U.S. Treasury notes even if the more distant forward rates remain unchanged.

Translation: I thought raising short rates would increase long rates.

Reality: By the time the Fed starts to increase short rates, it is usually late cycle. And markets become concerned about overheating, overtightening and recessions. That’s the macro.

The flattening of the curve under Greenspan was a sign the Fed’s policy was become tighter. Greenspan, and later Bernanke, ignored this signal. And they tightening right up until the curve inverted.

The Play: So the play with Greenspan was to understand as the New York Times put it then “that the central bank would keep raising short-term interest rates without any pause in the months ahead” — and to realize that this would potentially create an overtightening situation that led to a recession. It did

Right now, the same play is on offer. The difference is that the Fed gives more lip service to watching the yield curve. And the Fed is less aggressive in normalizing policy rates. I would say the relative value of going longer duration is less promising now than it was in 2005, 2006, or 2007.

What about the currency and other factors?

But having said that, I do think the Fed is more aggressive than the rest of the world. And so the play would be longer-dated US Treasury bonds versus either longer-dated German Bunds or longer-dated Italian government bonds.

The first effect is currency. If the currency is the release valve and the Fed is expected to be relatively tighter than other central banks, especially in a situation where euro area growth seems to be weakening, then you would expect the USD to hold steady or appreciate.

The second effect is the yield spread. For example, German 10-year yields are 0.29% right now. The US is trading at 2.83% or 254 basis points wide of bunds. I would expect that number to go down over time as the Fed overtightens.

The third effect is default or redenomination risk. And this is where Italy comes into play. Italy is trading 11 basis points narrower than the US for 10-year paper. But that 11 basis point differential is not based on the CB as it is with Germany. There are 243 basis points between German and Italian yields and that’s redenomination and default risk. So to the degree that the euro area worsens, Italian yields would not trade down, they would trade up. So in a situation in which the US overtightens and the euro area weakens you get all three effects with Italian bonds.

Divergent macro are losers in up markets

So that’s the way to look at a macro bond play as the cycle comes to its end. At the same time, let’s recognize that we’re in a cyclical upswing in 7 or 8 cases out of 10. Trying to build a bearish macro thesis or just one that diverges from the bullish market sentiment is going to be hard. Divergent macro is about downside risk and volatility, not continued economic expansion and bull markets in risk assets.

Right now, we are still very much in the bull market phase. So the number of macro theses which make money are limited. US curve flattening and the prospect of Fed overtightening presents the best risk/reward on that front right now. When the credit cycle turns, there will be a lot of other strategies to choose from. We’re just not there yet.


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